COMMENTARY – The cause of gold’s demise

Prominent Wall Street firms, influential news columnists and central bankers have been slamming gold as dead, a relic of the past, a stupid investment, and worse. In recent weeks, long-standing expectations that the gold price would increase in times of international turmoil, such as the war in Kosovo, or when inflation picked up, have been shattered.

Not only has the trading infrastructure of the gold industry been decimated, but the physical infrastructure is not being maintained. More than 100,000 miners in South Africa and elsewhere have been fired, and mining operations are closing. Those who gain their livelihood from gold are in shock. Some see dark conspiracies. Others blame misguided central bank policy, which they hope to rectify by lobbying central bankers. But most are just totally bewildered.

The core of the problem has to do with the fundamental use of gold as money.

In the nineteenth century, this was a central issue and widely debated.

Major political campaigns were fought over it for 100 years. It was called the “money issue,” and gold, the choice of the people, won decisively. In this century, that victory has been completely undermined. The result has meant unfathomable hardship for hundreds of millions. It is late in the day, but the gold fraternity can still save itself.

Before dealing with the problem, the key reasons why the gold industry is being destroyed must be understood. Gold limits money creation, which, in turn, limits bank profits. The 1947 edition of The Federal Reserve System — Purpose and Functions states: “Gold certificate holdings of the Federal Reserve Banks set the limit of Federal Reserve credit expansion.” Specifically, there was a statutory link between the amount of gold owned by the Treasury and the amount of credit that the Federal Reserve could create.

Because of the fiction of “required reserves,” this also limited commercial bank credit expansion and concomitant commercial bank profits. Today, as then, Federal Reserve and commercial bank credit creation is equivalent to money creation.

Also, in 1947, foreign central banks still had the right to redeem dollars for gold at US$35 per ounce. As a result, even though it was a felony for U.S. citizens to own gold, the public had some sense that gold limited money creation. Now that the statutory link between gold and bank credit-money creation has been broken, the amount of money that the U.S. and foreign banking systems can create is unlimited (This money is described as “fiat,” and has no backing). The crucial issue for the gold industry is that commercial banks have always understood that gold impedes their profits.

Putatively, credit creation by commercial banks is regulated by the Federal Reserve. But, as a practical matter, the Federal Reserve was created by their lobbying and has always been under the de facto control of large banks. While it is true that selecting the board of governors falls to the president of the United States, he looks to the financial community for recommendations.

Even Congress, which is charged with vetting and approving candidates, looks to the financial community elite to confirm approval. For example, the Wall Street Journal recently reported that the White House is leaning toward nominating Carol Parry, an executive vice-president of Chase Manhattan, as a replacement for outgoing Federal Reserve Vice-Chairman Alice Rivlin.

Even more telling, the original Federal Reserve legislation provided for a body called the Federal Advisory Council (FAC), whose members are selected by the boards of directors of the Federal Reserve banks. Today, FAC members consist of the top management of banks, whose assets total more than US$1 trillion. FAC members meet regularly with the board of governors to air their concerns and provide advice. Contrary to the principles of participatory democracy and an informed electorate, these meetings are held in secret, with no oversight. No other regulatory agency meets in secret with those it regulates.

Fifty years of empirical evidence confirms that removing the gold constraint allows the banking system to expand greatly. The amount of money in the U.S.

in 1946 was about US$150 billion. After the last tie to gold was severed in 1971, money creation exploded to more than US$6 trillion. Of that, roughly US$500 billion was created by the Federal Reserve. The balance of US$5.5 trillion was created by commercial banks.

Money creation is extraordinarily profitable for commercial banks. In 1997, U.S. banks reported after-tax profits of nearly US$60 billion. To put this in perspective, the profits of the automobile industry for the same period were less than US$10 billion.

The preceding is the first of two columns outlining gold’s decline and solutions for its recovery. The author is the executive director of the Foundation for the Advancement of Monetary Education, based in New York, N.Y.